Brexit and the UK's public finances - IFS

1 Brexit and the UK's public FinancesCarl Emmerson Paul JohnsonIan Mitchell David Phillips IFS Report 116 Brexit and the UK s public finances Carl Emmerson Institute for Fiscal Studies Paul Johnson Institute for Fiscal Studies Ian Mitchell Institute for Fiscal Studies David Phillips Institute for Fiscal Studies Copy- edited by Judith Payne Institute for Fiscal Studies 7 Ridgmount Street London WC1E 7AE Published by The Institute for Fiscal Studies 7 Ridgmount Street London WC1E 7AE Tel: +44 (0) 20-7291 4800 Fax: +44 (0) 20-7323 4780 Email: Website: The Institute for Fiscal Studies, May 2016 ISBN 978-1-911102-13-7 Preface The authors gratefully acknowledge support from the Economic and Social Research Council s The UK in a Changing Europe Initiative ( ). Co-funding was provided by the ESRC Centre for the Microeconomic Analysis of public Policy (CPP), grant number ES/M010147/1, which is based at the Institute for Fiscal Studies (IFS).

2 Contents Executive Summary 1 1. Introduction 7 2. The Direct Impact of Brexit on the public finances 8 How much does the UK contribute to the EU and how does it affect the public finances ? 8 What can other countries tell us about what the UK might contribute to the EU following Brexit ? 12 3. Brexit and the UK s National Income 17 Overview of economic assessments of Brexit 17 Economic relationship with the EU 19 Policy options for the UK outside of the EU 23 Key issues and why the assessments differ 28 Conclusion on short and long-term economic impacts 46 4. Brexit and the UK s public finances 50 Impact of changes in national income on the public finances 50 Scenarios for the short-term impact on borrowing 55 Scenarios for the long-run public finance impact 61 Conclusion 64 5. Conclusion 66 Appendix A. Possible reasons for deviations in the impact of national income on the public finances 68 References 72 1 Institute for Fiscal Studies Executive Summary If the result of the referendum on 23 June leads to the UK leaving the EU, there will be impacts on the UK public finances .

3 This report aims to set out the possible impacts, fo cusing particularly on the short run, given that the Chancellor wishes to achieve a budget balance by the end of this parliament. We also look at possible long-run consequences. The overall impact on the public finances will depend on two distinct components, each of which is uncertain to some degree: The mechanical effect. As a net contributor to the EU, leaving the EU would strengthen the public finances because our net contribution would fall. But given uncertainty over the form of any subsequent arrangement with the EU, it might not necessarily fall to zero. The national income effect. Any effect of leaving the EU on UK national income would affect the public finances . A rise in national income would strengthen the public finances , a fall would weaken them. The mechanical effect The UK s notional gross contribution ( ignoring the UK s rebate) in 2014 was billion, which is about 1% of GDP.

4 It is by dividing this number by 52 weeks that one comes to the widely-reported figure of over 350 million a week as the UK s contribution to the EU. But in this context, ignoring the rebate is clearly inappropriate. It is equivalent to suggesting that were the UK to leave the EU and not make any financial contribution to the EU s budget then remaining EU members would continue to pay the rebate to the UK. That is clearly absurd. The correct figure to use for the UK s gross financial contribution takes account of the rebate. It stood at billion, or of GDP, in (This is equivalent to around 275 million a week.) In principle, the UK s public finances could be strengthened by that full billion a year if we were to leave the EU. However, the EU returns a significant fraction of that each year. The amount varies, but on average our net contribution stands at around 8 billion a year.

5 That is 8 billion a year that we could use to fund other spending, cut taxes or reduce the deficit. Table 1 shows these direct, mechanical effects on the UK s budget. If we decided to spend less on agriculture, rural development, regional support or university research, we would be able to boost the 8 billion of available money though obviously at the expense of current recipients who would lose out from such a change. 1 Figures from HM Treasury (2015). Brexit and the UK s public finances 2 Table 1. The UK s financial contribution to the EU Budget, 2013 and 2014 % of GDP bn m per week 2013 Gross contribution 350 Contribution net of rebate 275 Contribution net of rebate and spending by the EU in the UK 175 2014 Gross contribution 350 Contribution net of rebate 275 Contribution net of rebate and spending by the EU in the UK 100 Approximate likely contribution net of rebate and spending by the EU in the UK going forwards 8 150 Note: Full details available in Browne, Johnson and Phillips (2016).

6 Spending per week rounded to the nearest 25 million. There is uncertainty about what trade deal we would negotiate after leaving the EU. Key Brexit campaigners seem to have ruled out any deal that would involve membership of the European Economic Area (EEA), like Norway. In part, that is because the UK would likely have to make a significant contribution to the EU budget in those circumstances. If the UK were to make proportionally the same net contributions that Norway makes, for instance, these might amount to about half our current net contribution, leaving us with a strengthening of the public finances of around 4 billion. The precise amount would depend on negotiations and what, if any, EU programmes the UK decided to participate in. (The actual financial flows between the EU and Norway are more opaque than one might expect.) Looser arrangements such as those agreed with Canada could allow the UK to avoid paying into the EU budget but would entail less access to the EU s markets, especially in services.

7 It is worth noting that no country outside the EEA has full access to the EU s financial services markets not even Switzerland, which does contribute to regional development funding (albeit to a lesser extent than EEA members such as Norway). The national income effect If leaving the EU were to have no effect on national income, then the public finances would be unambiguously strengthened. However, the public finances are sensitive to even relatively small changes in national income. So if the economy were to be just 1% bigger or smaller, then borrowing as a share of national income could in today s terms be around 14 billion less or more as a result. If Executive summary 3 leaving the EU were to reduce national income by just , that would be enough to outweigh the positive effect on the public finances of freeing up the net 8 billion that we currently contribute to the EU. Clearly if we were to strike a deal similar to the Norwegian one that involved us continuing to make a net financial contribution to the EU, then even smaller negative GDP effects would be enough to overwhelm the direct effect.

8 The precise effect of leaving the EU on national income is uncertain. There is uncertainty about the precise deal we would reach on trade; there is uncertainty about how much of the freedom to, for example, change regulations (including immigration policy) would be used; and there is uncertainty over the effects of each of these on growth. When thinking about the effects on national income, it also matters whether we are looking at a short-term or a long-term effect. A number of studies have been carried out on the likely effects on national income. There is a range of estimates for each. Short-term effects Of the 14 organisations we have been able to find that have quantified the short-run effects on national income, 12 suggest the effects would be negative, one (broadly) neutral, and one (Economists for Brexit ) suggests a positive effect on national income. This does not include the Bank of England, which, whilst not quantifying the likely effect, has nevertheless made it clear that it believes there could be a significant negative effect (Bank of England, 2016).

9 These negative effects in the first few years following a vote to leave are driven by a combination of an increase in uncertainty, a likely fall in the value of sterling and increase in inflation, an increased cost of borrowing, and the first impacts of the longer-run effects on, among other things, trade (see below). The increase in uncertainty in particular would be likely to drive a reduction in both consumption and investment, particularly foreign direct investment, with a direct effect on GDP as well as, in the case of the latter, a potential longer-term negative effect on productivity. The estimates of short-run effects range from reducing GDP by 6% (Soci t G n rale and the Treasury s severe shock scenario) to increasing it by (Economists for Brexit ). Within these estimates, those by the National Institute of Economic and Social Research (NIESR) are based on a particularly comprehensive economic modelling exercise.

10 Its estimates also happen to lie towards the middle of the range of estimates. NIESR s most optimistic scenario one that depends on the UK signing up to the EEA implies a GDP loss of in 2019 relative to what GDP would have been had we stayed in the EU. The most pessimistic scenario it reports, which assumes no special free trade deal with the EU, would see GDP lower than otherwise in 2019. This latter scenario is also modelled by the Treasury as a severe shock , which suggests a 6% hit to GDP two years after a Brexit vote. Brexit and the UK s public finances 4 We estimate that if NIESR has broadly the right range of possible outcomes for GDP, then the budget deficit in 2019 20 would be between about 20 billion and 40 billion higher than otherwise. In the Treasury s analysis, they estimate that their short-term hit to GDP results in a much smaller increase in public sector net borrowing than our estimates imply.